The sale of a disregarded entity has two possible federal tax treatments, and which one applies depends entirely on who ends up owning the business after closing. If you sell your whole interest to a single buyer, the IRS ignores the entity and treats the deal as a direct sale of each underlying asset. If you sell only part of your interest, or sell the whole thing to two or more buyers, the entity becomes a partnership in the same breath, and the transaction is recharacterized under partnership rules. The split can swing your effective tax rate by tens of percentage points depending on what the business owns.
A disregarded entity, most often a single-member LLC that hasn’t elected corporate status, exists under state law but not for federal income tax purposes. Revenue, expenses, and now sale proceeds all flow onto the owner’s personal return.1Internal Revenue Service. Single Member Limited Liability Companies Because the IRS doesn’t see the entity, it can’t see a transfer of membership interests in isolation. The buyer’s identity, and how many buyers there are, controls everything that follows.
Selling 100% to One Buyer: Deemed Asset Sale
A sale of the entire interest to a single buyer is treated as if you sold each individual asset of the business directly. The membership interest the legal documents transfer is invisible for tax purposes; only the underlying property is real to the IRS.
That means you and the buyer must allocate the purchase price across every asset and report the allocation on Form 8594, Asset Acquisition Statement Under Section 1060.2Internal Revenue Service. About Form 8594, Asset Acquisition Statement Under Section 1060 Both parties file the form, and the numbers have to match. Mismatched allocations draw IRS attention.
Each asset then generates its own gain or loss with its own character. Equipment might throw off ordinary income through depreciation recapture, real property might land at a 25% rate, goodwill might qualify for long-term capital gain treatment, and inventory always produces ordinary income. One closing can touch four different tax rates in the same year.
Selling a Partial Interest or to Multiple Buyers
The moment the entity ends up with more than one owner, it stops being disregarded. An entity with two or more owners is classified as a partnership by default.3eCFR. 26 CFR 301.7701-3 – Classification of Certain Business Entities
Revenue Ruling 99-5 lays out the mechanics. A sale of a partial interest is recharacterized as two steps: the buyer is first treated as purchasing a proportionate share of each underlying asset directly from the seller, and then both parties are treated as contributing their respective shares to a newly formed partnership in exchange for partnership interests.4Internal Revenue Service. IRS Chief Counsel Advice 0825008 The buyer’s cash goes to you as the seller, not to the new partnership.
The seller’s gain is then characterized as the sale of a partnership interest. Under Section 741, that generally produces capital gain.5Office of the Law Revision Counsel. 26 USC 741 – Recognition and Character of Gain or Loss on Sale or Exchange That sounds cleaner than the asset-by-asset breakdown of a full sale, but Section 751 pulls back any gain attributable to “hot assets,” meaning unrealized receivables and inventory, and recharacterizes it as ordinary income.6Office of the Law Revision Counsel. 26 USC 751 – Unrealized Receivables and Inventory Items A service business with large receivables may see most of its gain pulled back out of capital gain treatment.
How the Purchase Price Gets Split Across Assets
In a deemed asset sale, Section 1060 requires the residual method of allocation.7Office of the Law Revision Counsel. 26 USC 1060 – Special Allocation Rules for Certain Asset Acquisitions The price fills seven asset classes in a fixed order, starting with cash and ending with goodwill. Each class absorbs value up to its fair market value, and whatever is left after Classes I through VI falls to Class VII, goodwill and going concern value.8Internal Revenue Service. Instructions for Form 8594
The allocation drives the tax bill. More value in inventory (Class IV) and depreciated equipment (Class V) means more ordinary income for the seller. More value in goodwill (Class VII) typically means more long-term capital gain. Buyers usually push for allocations that frontload depreciable and amortizable assets, since those generate faster deductions. Sellers push the other direction. The negotiation is one of the highest-leverage moves in the whole transaction, and it needs to happen before the closing documents are final.
Character of the Seller’s Gain
Because a deemed asset sale calculates gain on each asset separately, the character of your total gain is a blend. The mix depends on what the business owns and how aggressively you’ve depreciated it.
Depreciation Recapture
Recapture is usually the biggest source of ordinary income in a business sale. Under Section 1245, gain on tangible personal property (equipment, vehicles, furniture) up to the total depreciation you previously claimed is taxed as ordinary income.9Office of the Law Revision Counsel. 26 USC 1245 – Gain From Dispositions of Certain Depreciable Property Only gain exceeding that depreciation qualifies for capital gain rates.
Real property runs on separate rules under Section 1250.10Office of the Law Revision Counsel. 26 USC 1250 – Gain From Dispositions of Certain Depreciable Realty For buildings, the portion of gain tied to prior depreciation (unrecaptured Section 1250 gain) is taxed at a maximum of 25%, a middle tier between ordinary income and the preferential capital gains rates.11Office of the Law Revision Counsel. 26 USC 1 – Tax Imposed Gain above that is long-term capital gain at 0%, 15%, or 20%.
Section 1231 Property
Depreciable property and real property used in your business and held for more than a year is Section 1231 property.12Office of the Law Revision Counsel. 26 USC 1231 – Property Used in the Trade or Business and Involuntary Conversions If your net Section 1231 result for the year is a gain, it’s treated as long-term capital gain. If it’s a loss, it’s treated as an ordinary loss, which can offset any kind of income without the $3,000 capital loss cap.
Watch the lookback rule. If you claimed ordinary loss treatment on net Section 1231 losses in any of the five preceding tax years, an equivalent amount of this year’s Section 1231 gain is recharacterized as ordinary income.
Goodwill
The residual value that lands in Class VII generally qualifies as long-term capital gain if you’ve run the business for more than a year. For most service businesses and established companies, goodwill is where the largest share of the price ends up, which is where the bulk of favorable capital gain treatment comes from. For 2026, the long-term capital gains rates are 0%, 15%, and 20%, with the 20% bracket starting at $545,500 of taxable income for single filers and $613,700 for joint filers.13Internal Revenue Service. Topic No. 409, Capital Gains and Losses
The 3.8% Net Investment Income Tax
On top of regular income tax, gain from a business sale can trigger the 3.8% Net Investment Income Tax. NIIT applies to individuals with modified adjusted gross income above $200,000 (single) or $250,000 (married filing jointly). Those thresholds aren’t indexed for inflation.14Internal Revenue Service. Questions and Answers on the Net Investment Income Tax
There’s an important carve-out. If you materially participated in the business, gain from the sale of property used in that active trade or business can be excluded from the NIIT calculation. A hands-on single-member LLC owner is in a much better position here than someone who held the entity as a passive investment.
The QBI Deduction Won’t Help
Owners sometimes expect the 20% qualified business income deduction under Section 199A to soften the hit. It doesn’t. QBI specifically excludes capital gains and losses.15Internal Revenue Service. Qualified Business Income Deduction The deduction covers ongoing operating income, not sale proceeds. Plan your projected tax bill without it.
Installment Sales Have Big Exceptions
If the buyer pays over multiple years, the installment method can spread the taxable gain across the years you actually receive payments rather than concentrating it in the year of sale.16Office of the Law Revision Counsel. 26 USC 453 – Installment Method For a large deal, that can keep you in a lower bracket and defer significant tax.
Two carve-outs matter. Inventory can’t use the installment method at all; all inventory gain is reported in the year of sale no matter when the cash arrives.17Internal Revenue Service. Publication 537, Installment Sales Depreciation recapture under Section 1245 or Section 1250 also can’t be deferred and must be reported in full in the year of sale.18Internal Revenue Service. Topic No. 705, Installment Sales Only gain above the recapture amount on eligible property can be stretched out. Sellers get caught by this regularly: tax on the recapture is due now, but the cash to pay it may not arrive until year two or three of the note.
Estimated Tax After Closing
A sale can generate a tax bill far larger than any withholding covers. Because the gain lands on your individual return with no employer withholding to absorb it, you’ll likely need to make an estimated payment by the next quarterly deadline after closing to avoid an underpayment penalty.19Taxpayer Advocate Service. Making Estimated Tax Payments The safe harbor generally requires paying 110% of last year’s tax (for higher-income taxpayers) or 90% of this year’s through withholding and estimated payments combined. A sale that doubles or triples your income blows past most safe harbors, so run the numbers with a tax professional shortly after the deal closes.
What the Buyer Gets
Buying 100%
A buyer who takes the entire interest gets one of the cleanest outcomes in business M&A: a full stepped-up basis in every asset, equal to the amount allocated to it on Form 8594.8Internal Revenue Service. Instructions for Form 8594 Tangible assets can be depreciated based on the actual purchase price rather than the seller’s old, often fully depreciated, basis.
Value allocated to intangibles, including Class VI items (customer lists, trademarks, noncompete agreements) and Class VII goodwill, is amortized over 15 years starting in the month of acquisition under Section 197.20Office of the Law Revision Counsel. 26 USC 197 – Amortization of Goodwill and Certain Other Intangibles For a business purchased mostly for its reputation and customer relationships, that’s a steady stream of deductions for the next decade and a half.
Buying a Partial Interest
A partial buyer ends up with a partnership interest, not direct ownership of assets. Outside basis in the partnership interest reflects the purchase price, but the partnership’s inside basis in its underlying assets still reflects the original owner’s historical cost. The buyer paid for more than the assets are “worth” on the partnership’s books.
A Section 754 election fixes this.21Office of the Law Revision Counsel. 26 USC 754 – Manner of Electing Optional Adjustment to Basis of Partnership Property The election adjusts inside basis to reflect the new partner’s purchase price, but only with respect to that partner. Without it, the buyer essentially overpays for basis that can’t generate deductions until the partnership sells or distributes the asset.22Internal Revenue Service.